Streetwise Professor

The FT ran a rather bizarre editorial on end user exemptions from clearing mandates.  As seems to be the wont of clearing advocates of late, it is strident, but hardly persuasive.

Here’s the core of the argument:

But the fact that reform might impose higher costs on non-financials is precisely the reason for sticking to it. Costly margin requirements indicate that the derivatives companies purchase not only insure them against adverse market movements but can require them to make substantial payments should market conditions move against them. If OTC derivatives are cheaper than taking out insurance, this suggests that the systemic risks of the OTC market and the banks that dominate it are being borne by taxpayers. Ending this subsidy would force corporations to bear the fair economic cost of their actions.

This is apparently the S&M theory of public policy: unless a policy inflicts pain, it is ineffective.  The more costly a policy is, the better it must be!

Here’s my most charitable characterization of the argument:  Due to Too Big to Fail, banks subsidize their customers.  In particular, they subsidize them by taking on default risk and not charging for it.  Therefore, it is necessary to impose costs on these customers in the form of collateral requirements in order to eliminate the subsidy.

Here is one testable implication of this theory: in the absence of TBTF subsidies, all deals will be fully collateralized.

This implication is refuted by experience.  For instance, prior to the formation of the Chicago Board of Trade Clearing Corporation (under government pressure), margining was discretionary.  Exchange rules permitted parties to demand margin: it did not require it.  Routinely brokerages extended credit to their customers and to other brokerages that they traded, and did not require the posting of initial margins, and only required posting of variation margins when a pre-established  credit limit was breached.  These brokers were not the beneficiaries of any TBTF subsidy.  So, credit exposure via incomplete collateralization existed even in the absence of a TBTF subsidy.

Moreover, this theory doesn’t explain why the credit terms extended by OTC dealers vary by customer and deal.  Such variation in credit terms means that dealers are evaluating credit and charging for it based on the nature of the customer and the trade.  Of course, it is possible that these terms are too generous overall (due to TBTF) but the behavior of dealers belies the simplistic story that the FT spins, to the effect that dealers don’t care about credit risk in doing derivatives deals, and hence it is necessary to deny them the discretion to choose their own credit terms.

Furthermore, the FT editorial, like much of the pro-clearing discussion, implicitly assumes that everything else will remain the same after the imposition of a clearing mandate; collateralization will reduce counterparty risk in derivatives trades, and other credit risks will remain unchanged, so overall banks will face fewer default risks.  This is certainly incorrect, and market participants will respond to a mandate by taking actions that undo much of its effect.

For instance, the mandate that all deals be collateralized effectively tells dealers: Thou shall not extend credit through derivatives transactions.  But there are multiple ways that dealers can extend their customers credit.  In particular, if precluded from extending unsecured credit through a derivatives trade, they can substitute other forms of unsecured credit for that they would have offered their customers via derivatives.  Now, revealed preference implies that this is not the preferred arrangement, as otherwise end users and dealers would have chosen it in the first place.  But the use of other forms of credit to finance, effectively, margin/collateral will almost certainly be a second best response to the mandate.  Thus, collateral requirements will do far less to reduce the amount of credit and leverage in the system than their advocates believe.

Moreover, and perhaps more importantly, if TBTF subsidies are the Original Sin, merely foreclosing one way to exploit these subsidies will have little effect on the riskiness of banks.  So if dealers are foreclosed from exploiting TBTF subsidies in their derivatives business, they have every incentive to find other ways to do so.  And they are sure to be creative.

That is, TBTF subsidies are like water.  They will find some outlet.  Dam up one outlet, and the water will find its level through some other channel.  So maybe OTC derivatives won’t be the source of the next crisis (just as they weren’t the source of the last crisis), but if TBTF continues to exist, risk taking will be continued to be subsidized, some excessive risks will be undertaken somewhere, and inevitably, this will cause problems down the road.

But whatever the next crisis, we may be able take comfort that derivatives will not have caused it.  Very cold comfort.

There will be other unintended consequences.  Even though dealers and other intermediaries are likely to try to design financing methods and provide services that reduce the operational and financial burden of end user collateral requirements, again by revealed preference, these alternatives are more burdensome to end users than the incumbent system.  As a result, some end users will decide not to hedge; others will hedge less.  Others will adopt different capital structures that are less efficient.  As a result, more end users will suffer financial distress, and others will incur costs in the form of less efficient investment policies, etc.  These are real costs.  And they can result in defaults–just not on derivatives trades.  Are we really better off when a firm that eschews hedging because of the higher burden inherent in collateralization defaults on its debt to a bank when the risk it would have hedged comes to pass?

If TBTF is the real problem, it is counterproductive to try to address it through micromanaging the ways that financial institutions  attempt to exploit the TBTF subsidy.  Deal with the real problem–the subsidy–rather than attempt to anticipate and foreclose every possible way that clever bankers can attempt to milk this subsidy.  Deal with TBTF upstream, not downstream.

Like a child’s security blanket, clearing and collateral mandates give some a sense of warmth and security.  And a false sense of security, as it turns out, because they do not eliminate or even reduce substantially the true source of danger in financial markets.

I saw the headline of this Matt Leising article, “Lehman Derivatives Records a Mess,” and reflexively thought it would be about its OTC trades (of which there were, if memory serves, over 900,000 if memory serves).

I was wrong.  It was about its exchange traded–and cleared–positions:

Barclays PLC had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.

“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.

She said she received an e-mail from former Barclays trading executive Stephen King saying Lehman had “absolutely no idea” if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.

. . . .

Transferring margin together with trading positions “is normal practice in the ETD business,” she told U.S. Bankruptcy Judge James Peck, referring to Lehman’s exchange-traded derivatives. “You’d be crazy if you didn’t.”

She said Lehman’s lack of records initially prevented her from performing “due diligence” to discover what Lehman’s and its customers’ positions were, where Lehman kept its bank accounts, and who its brokers were.

James said she had seen a tabulation of Lehman’s positions at the Options Clearing Corp. showing that the daily margin requirements for its trades had varied by as much as $1 billion within a few days in September 2008.

Moral of the story: moving more trading to exchanges, exchange-like systems, and clearing will not necessarily lead to greater clarity about the positions that big entities like Lehman hold.  One of the arguments for clearing has been that it will improve regulatory transparency, and help regulators figure out where the risk is and who is exposed to whom.  Even overlooking the basic fact that it is possible to have centralized trade reporting without mutualizing credit risk through clearing, the Lehman story shows that this alleged advantage has been vastly oversold.

Big complicated firms have big, complicated, and dynamic positions that are hard to keep track of, regardless of where and how they are traded.  There is a long, long, long way to go before even approaching the ideal of “mapping” risk in the financial system.  More centralized collection of information is a necessary, but by no means sufficient, condition to achieve this goal.

The Lehman story should be a cautionary tale to all those who naively believe that waving a legislative wand and casting a spell that drives trading to exchanges will magically eliminate all of the huge operational difficulties associated with measuring and managing risk.

Back in the Dark Ages, I wrote my PhD thesis on the ocean shipping industry.  Specifically, I applied core theory to explain the diversity of organization across different sectors of the shipping business, with collusion in the liner (container) business, and competition in the bulk sector.  Not long after going into academia, I realized that the core theory thing was a dead end professionally, so I remade myself into a derivatives scholar.

Well, reading the Economist this week, I had a peanut butter-chocolate Reese’s moment: the magazine ran an article about derivatives on container shipping rates:

Clarksons, the world’s biggest shipbroker, which pioneered derivatives for dry-bulk cargoes like iron ore and coal in the early 1990s, made its first container-derivative trade in January this year. Since then two other London-based brokers, ICAP and Freight Investor Services, have also started to offer derivatives settled against the Shanghai Containerised freight index, which is based on per-box rates on the world’s busiest container routes. Alex Gray of Clarksons admits that the market is tiny at the moment. But he reckons that container derivatives may be worth 5-10% of the physical market by the end of 2011.

One interesting sidelight in the article:

Half the container fleet runs like a bus network with regular sailings at set times. With these ships, prices are set under long-term contracts. But the spot market, where vessels are chartered for specific trips or time periods, is very unpredictable, particularly since regulators put a stop two years ago to an arrangement between shipping lines (the top 15 of which control 80% of the market) to manage overcapacity by co-operating on routes and rates.

If this is an accurate description of the business, it’s changed a lot since I studied it in any detail.  The most interesting feature is the statement about regulators.  My thesis argued that the cost and demand structures in liner shipping (cost indivisibilities and highly divisible demand) made competition unstable, and that collusion (shipping conferences–“an arrangement between shipping lines . . . to manage overcapacity by co-operating on routes and rates”) was an efficient response.  If collusion is no longer permitted, then some alternative, e.g., more long term contracting, should develop.  (I also showed that long term contracts can mitigate the inefficiencies that exist with spot contracting.)

Anyways, it’s interesting to see the convergence of the two seemingly divergent issues that have defined my professional career.  Maybe it’s time to take another look at the shipping business.  (Don’t worry: I’ll still have time for you, Gary and Bart.)

In recent months, the owners of large pieces of Norilsk Nickel, Oleg Deripaska and Vladimir Potanin have gone to the mattresses for control of the company.  In response, Don Putin has felt compelled to fly to Norilsk in what is seen as part of a move to resolve the dispute. (And given what an ecological hellhole Norilsk is, you can be sure he isn’t going for the sights or the fresh air and waters.)

Although control contests are not unknown in the US or Europe, it is unheard of to see the head of government involved in resolving them.  That’s the role of the markets and the courts.

And it is the very absence of active markets and reliable courts that mean that Putin is needed to arbitrate and resolve these kinds of disputes.   Putin effectively recognizes this:

Commenting in 2008 on a shareholder conflict in the Russian subsidiary of the British oil major BP (BP.L) TNK-BP, where BP and a trio of Russian-born billionaires held 50 percent stakes, Putin said equal ownership did not work.

“I told them: ‘Don’t do it. Agree to one of you having a controlling stake,'” Putin said at the time.

In the absence of a controlling shareholder, in Russia business disputes resemble scenes from the Godfather or the Sopranos more than the kinds of business conflict you see here in the states.  And the institutional response in Russia is exactly analogous to the one that mafioso have evolved in Sicily and the US: to appoint a capo di tutti capi to knock heads when the capi fight over turf.  His job is essentially to ensure that rents and power are distributed in a way that mitigates the potential for conflict, and to crush those who threaten to destabilize the system.

This is part of the reason why Russia is doomed to economic stasis, at best.  This kind of system cannot readily deal with change that upsets the balance of rents and factions.  So dynamic forces have to be suppressed.  In a system like Russia’s, creative destruction is impossible.  There’s only destructive destruction.

And that’s the best case.  Worse cases are not improbable, and really bad.  In particular, if for any reason–death, incapacity, or just declining capacity–the capo di tutti capi can no longer function effectively, everyone goes to the mattresses in a war of all against all.  So stasis–Putin’s economic purgatory–is preferable to the most likely alternative.  Internecine warfare is the most likely alternative because the more civil, humane, and productive alternative–the creation of institutions that support markets and the constructive resolution of disputes–is devilishly hard, especially so since those who would have to lead (or at least consent to) the creation of these institutions would lose wealth and power as a result.  I think that the widespread recognition of these conditions also explains popular support for Putin, or at least a good deal of it.  If you take for granted that the system is essentially mafia-like, you want a good capo that can maintain equilibrium.  And whatever you might say about him, Putin plays the role quite well.

There was a kerfuffle earlier this week when the CFTC said that Exchange of Futures for Futures transactions–EFFs–were legal, despite the CME’s claim that they were banned wash trades.  There has been some breathless commentary that this is a grave competitive threat to CME, and raises the specter of “fungibility,” meaning that clearing and execution would effectively be unbundled.  A trade could be traded on one exchange, and then cleared elsewhere.  This would, supposedly, increase the competition that the CME would face.

I rolled this rock up the hill too many times pre-crisis, when fungibility was a headline issue before it was overshadowed by the crisis and its effects.   For instance, this was a big issue in the DOJ’s infamous passive-aggressive letter in the winter of ’08.

So, let me say it yet again.  As the Chicago School of Antitrust Economics pointed out long ago, if clearing is the source of the CME’s market power (as the advocates of fungibility claim), the CME could maximize the profits it earns by charging the appropriate price for clearing services.  It would have no incentive to tie execution and clearing.  Indeed, it would have an incentive to encourage competition in execution in order to maximize the derived demand for its (monopoly) clearing services.

So, the argument that tying execution and clearing is anti-competitive is fundamentally flawed.  There is another purpose for it.

I should also note that even with fungibility, the CME competitor ELX will face daunting obstacles in challenging CME in execution.  That’s because clearing is not the only source of scale economies in providing trading services.  Due to the effects of liquidity, there are huge scale economies in execution as well.  Price impact costs are far smaller in bigger, more liquid markets.

Indeed, it is the existence of large scale economies in clearing and execution which, in my view, drive the integration/bundling of the two services.  Integrating back-to-back monopolies economizes on transactions costs.

But integration does not require bundling of the services.  So why does CME insist on doing so?  (I.E. why do you have to trade on the CME to clear on the CME?)  The most likely explanation is that it wants control over access to the clearinghouse for risk management and control reasons.  The CME wants control over whose risk it takes and whose risk it guarantees.  EFFs could call that into question.  But if that’s the case, the CME would be advised to make it straight up, rather than relying on the wash trade argument.

I called this a kerfuffle because I don’t think EFFs will catapult ELX into contention in head-to-head competition with CME.  The CME’s liquidity advantages are too great.  This will get ELX some headlines, but not much business.

Update (1145 CT, 8/19/10). Last night, after posting this, I read something from the CME that was sent to me before I’d written the post.  It makes the “clearinghouse control” argument “straight up.”  Responding to a Consultative Paper issued by Center of European Securities Regulators, CME CEO Craig Donohue wrote:

[F]ungibility (i.e., one contract could be substituted for another contract) is not necessary or desirable.  Fungibility for OTC derivatives contracts across multiple exchanges or trading venues serves only to provide linkages, or interoperability, among various clearing houses providing clearing services for the exchanges or trading venues listing such contracts.  Interoperability among clearinghouses increases systemic risk to each clearing house and the financial system as a whole.  Indeed, when one side of a matched trade is transferred, the original clearing house automatically becomes exposed to the risk of the other clearing house.  As transfers build and links between clearing houses increase, the ability to contain a single failure decreases and the risk throughout the system increases.

So, CME is making the risk control argument in a straightforward way.

This is a good response to Bill’s question in his comment.  The key issue is one-sided transfers.  Before an EFF, trader A’s counterparty is the CCP of the original exchange (CCP1).  CCP1 has an offsetting position with A’s original trading party, B say.  If A executes an EFF with an exchange using CCP2, since both CCP1 and CCP2 have to have zero net positions, and the EFF doesn’t change CCP1’s position with B, the chain of contracts is now:  A has a position with CCP1; CCP1 has an offsetting exposure with CCP2; and CCP2 has its original exposure with B.  Thus, giving A the unilateral right to EFF into CCP1 allows him to create an inter-CCP exposure without CCP1’s consent.  CCP1 may not want to be exposed to CCP2, for both risk and operational reasons.  From a systemic risk perspective, too, this creates the dread interconnections that clearing is intended (by the ignorant, admittedly) to eliminate.

Hope that helps, Bill and BwO.

As an aside, the Donohue letter does go on to say that the CME endorses “open access” to CCPs.  The distinction is that open access as the CME uses the term means that end users can choose their clearinghouse when doing a cleared OTC deal, and if they enter into offsetting trades with different dealers, direct the trade to the original CCP in order to liquidate a position.

In response to BwO’s comment.  The argument in a nutshell is that monopoly leveraging is generally unprofitable.  Assume that product M is monopolized, and product C is competitive.  Can the monopolist increase profits by requiring that anybody who buys M also buy C from it?  Except under special conditions, the answer is no.  This is because consumers may not like the monopolist’s variety of C.  They are willing to pay less for the M+C bundle provided by the monopolist than they are for a bundle of M and their preferred variety of C.  This means that bundling reduces the demand for M, reducing the price that the monopolist can charge.  The demand for his product–and his profit–is greatest when he lets customers choose their preferred variety of C, and he charges the monopoly price corresponding to this higher demand curve.  (A similar argument holds with respect to the case where the M monopolist is not the low cost producer of C).

So, except under highly unusual circumstances (which I discuss next) it is absolutely NOT the case that “tying is anti-competitive bundling that parlays one monopoly into another monopoly.”  This has been widely understood in economics and anti-trust since the 1960s.  So yes I can argue that, and it has been argued since Bork, Posner, Director and others first addressed the issue, and virtually every model on the subject implies this result except if you build in some special (and usually contrived) conditions.  Even Whinston, who made his name on these alternative models, admits that there aren’t good practical examples of the factors he identifies leading to the anti-competitive result.

There are some counterexamples in the literature.  Hart and Tirole (1990) have one.  Whinston (1990) has several.  None of these models is remotely applicable to the case of clearing.

Carlton and Waldman (2002) have a very nice model specifically designed to address the Microsoft bundling issue in a two period model.  The key assumptions in their model is that the tied products are durable goods, and that any entrant cannot produce the monopoly product in the first period, but can produce the competitive one.  They show that under some conditions–not all–anti-competitive bundling might work here.  Neither of these assumptions is relevant in the clearing/execution context: these are not durable goods, and simultaneous entry by an integrated competitor is possible.  Nor is their assumption that one good is competitive and produced subject to constant returns to scale: in trading, both clearing and execution are subject to strong scale economies.  In this working paper I modify the Carlton-Waldman model, and show that in conditions that are most plausible in the clearing/execution setting, anti-competitive bundling is not likely to be a profit increasing strategy for the clearing monopolist.  That paper discusses the literature in some detail, and examines other transactions-cost based reasons for integration of clearing and execution.

Thanks for the comments.

I’ve written a lot about clearing mandates, but less on the Dodd-Frank Act’s attempts to alter the way derivatives trades are executed.  In part, this reflects the incredible uncertainty about just what a “swap execution facility” must be and do.

But, it is pretty evident that there is deep suspicion about bilateral OTC market dealings, both in Congress and especially among regulators.  CFTC Chairman Gary Gensler in particular has criticized bilateral trading mechanisms.  He, and many others, want to move the vast bulk of trading activity to exchange-like systems.  The standard argument is that the opaque OTC markets work to the advantage of dealers and to the disadvantage of customers.  The greater pre- and post-trade transparency in auction-based, order driven exchange markets, the story goes, will undermine the information advantage that dealers have in OTC markets, thereby eroding their profits.

As was routine in the clearing debate, this begs crucial questions.  Most importantly, why would customers choose to trade in opaque dealer markets?  Why can’t exchanges win in competition for customers with OTC dealers, if the former offer a better deal?

There is a tremendous diversity of trading mechanisms across products, and within products.  In products where exchanges compete with dealer markets, dealer market shares vary widely.  The dealer share is virtually 100 percent in FX and FX derivatives.   It is large–on the order of 80 percent–in linear interest rate derivatives.  It is closer to 50 percent in interest rate options and equity derivatives.  In the cash equity markets, a lot of trading took place on anonymous exchanges, but a good deal once took place in non-anonymous upstairs markets.  Nowadays, the upstairs markets are less important, but dark pools serve similar functions, notably facilitating large trades.  Cash Treasuries were long dealer markets, and still are to a large degree, although electronic markets have made in-roads.

There is also time series variation.  Biais and Green have an interesting paper that documents how the municipal and corporate bond markets migrated from exchange trading (on the NYSE) to a bilateral dealer market.

The simplistic “dealers scalp their poor customers” story doesn’t explain this cross sectional and time series variation in the market shares of “wholesale” dealer markets.  There must be something else going on.

What many of these off-exchange markets have in common is that they screen out informed trading.  Dark markets and third markets utilize screening technologies, or trading mechanisms that are unattractive to informed traders (e.g., crossing networks).  Others, like the upstairs markets, block markets, and OTC derivative and bond markets (govvies, corporate, and munis) rely on reputation, and are not anonymous.  Dealers reduce their risk of dealing with counterparties with private information by knowing who they trade with.  They are “opaque” in the sense that there is little pre- or post-trade transparency.  But they are far less opaque than exchange markets–especially electronic markets–in the crucial dimension of the observability of the identity of the counterparties.

The empirical evidence shows pretty conclusively that big traders incur much smaller trading costs by trading in these venues.  Which is pretty obvious: the big traders aren’t stupid, and are going to trade where they get the best prices.  The Biais-Green piece is interesting in this regard.  The market moved from exchange to OTC when insurance companies and pension funds began to dominate bond trading.

So, the claim that customers are victimized in dealer markets is hard to square with the evidence.  Big customers often benefit by trading in markets that are opaque in some dimensions, but transparent in others.  Dealer-based “wholesale” markets favor a particular kind of customer, and those customers choose to trade there.  They aren’t victims.

I am also less than persuaded that OTC market customers are all that ignorant about values.  For instance, a customer buying or selling an OTC interest rate swap can look to the Eurodollar futures market and to the Treasury futures as a source of information on the yield curve that they can utilize to evaluate the bids and offers of OTC dealers.  It’s even easier in the energy markets, to compare a dealers bid and offer on a NYMEX lookalike product with the real McCoy trading on the screen.  Moreover, those who are trading OTC have the opportunity to trade these close substitutes in highly liquid exchange markets–but they don’t.  Presumably because it is cheaper to trade off exchange than on, even though they are allegedly trading with rapacious dealers who keep them in the dark.

And this raises an issue that has been the focus of debates about “fragmentation” between exchange and dealer markets in the past, but which has strangely disappeared from sight in the current debate.  Once upon a time, a major objection to off-exchange trading was that “free rides” off of exchange price discovery, and worsens liquidity on the exchange market.  In essence, those who can verifiably demonstrate they are not privately informed can get lower trading costs by trading off exchange, thereby leaving those who cannot demonstrate that they are uninformed more vulnerable to trading against the informed, and incurring higher trading costs as a result.  That is, off exchange venues like block markets and dealer markets “skim the cream.”

This can’t be the case in some markets.  In corporates and munis, for instance, there’s no market to free ride off of, for all intents and purposes.

Even in markets where cream skimming and free riding are possible, it is not clear that the net effect of this is welfare reducing.  If the exchange market is perfectly competitive–and this is a huge if, and a huge implicit assumption in most of the literature on fragmentation and cream skimming–then the externality associated with price discovery means that off-exchange trading is welfare reducing.  But exchange markets are not necessarily perfectly competitive.  As I’ve shown in my academic work, exchanges exercise market power, through entry limits (e.g., limits on the number of exchange members), organizing member cartels, and super-marginal cost pricing.  They can do so because the “tippiness” of anonymous markets tends to make price discovery a natural monopoly.

If exchanges exercise market power, we aren’t in a first best world anymore, and therefore what would normally be considered a market failure–like an externality–can actually improve welfare.  I show this explicitly in a couple of papers, one published in the JLEO, and in a working paper titled “Third Markets and the Second Best.”  In these models, competition from off-exchange markets reduces exchange market power, leading to lower total execution costs (and higher aggregate surplus).

But even if this happens, off-exchange trading has distributive effects.  Those who can avail themselves of the off-exchange opportunities gain, those who can’t, don’t.  But the gains of the former are bigger than the losses of the latter.  These distributive effects are the reason, though, for the intense controversy over market structure.

This means that forcing trading onto exchanges can reduce competition and increase total trading costs.  Ironically, the biggest losers in this would be those who are ostensibly being helped: those who voluntarily choose to trade in dealer markets, like the OTC derivatives markets.

Some who fret about the persistence of opaque bilateral markets attribute their persistence to the “tippiness” of financial markets.  For instance, Biais and Green argue that muni and corporate bond markets have remained OTC because it is hard to tip order flow away from established markets.

I find this argument unpersuasive for two reasons.

First, and most importantly, tipping occurs in anonymous markets, as a consequence of informed trading.  The uninformed like to cluster in a single market because that minimizes their losses to the informed.  But the whole thing about many wholesale markets is that they allow the uninformed to avoid losing to the informed through another mechanism–transparency about trader identity and type.  Markets fragment between price discovery natural monopolies (where informed and uninformed trading take place) and other markets where less price discovery occurs because these trading mechanisms screen out many of the informed, making the uninformed who trade there better off.

Second, the tipping argument may be plausibly persuasive in corporates or munis, but not in many OTC derivative markets.  For instance, there are extremely liquid markets for Eurodollar and energy futures.  Traders who choose to trade OTC could avail themselves of this liquidity–but they don’t.  Again, because it is cheaper to trade someplace else.  Put differently, tipping may be able to explain something like munis where there’s only one market (though I doubt that): it cannot explain the side-by-side survival of two big markets, like Eurodollars and interest rate swaps.

In brief, there is a diversity of trading mechanisms because there is a diversity in trader types.  Forcing trading onto a one-size-fits-all platform will inevitably have distributive effects, and will almost certainly have efficiency effects too.   These efficiency effects are likely to be adverse, because anonymous trading venues where trades with private information can buy and sell tend to have market power.  Reducing competition from non-anonymous trading venues, like OTC dealer markets enhances the market power of the anonymous markets, and their owners can profit accordingly.  Moreover, in profiting, they price their services in a way that creates deadweight market power losses.

We should never expect financial markets to approximate even remotely perfectly competitive markets.  But fragmented markets in which some traders participate in face-to-face dealer markets can be better than having everybody trade on “transparent” exchanges.   This is because usual descriptions of transparency focus on price transparency, and that’s not all that matters.  Markets that offer the most price transparency often offer the least counterparty transparency.

Gary Genlser has repeatedly used the analogy of going to the store and buying an apple at a posted price to argue that everybody should want to trade on markets with pre-trade transparency.  But there is diversity even in apple markets: wholesale and retail markets are different, and offer different degrees of transparency.  The same can be said with even greater force in financial markets.

Which is why I conclude that if Gensler and those of like mind get their way, and succeed in forcing–yes, it would be by force–more trading onto anonymous, exchange-type markets, trading costs will rise and welfare will fall.  And the biggest losers will those who are the alleged victims of the lack of price transparency in OTC markets.  They will be losers because that lower price transparency is more than offset by other advantages of trading in non-anonymous markets.

Russia is going to ban wheat exports, and is “coordinating” with the members of its “Customs Union,” Kazakhstan and Belarus, to do the same.  This ban has caused a worldwide spike in wheat prices; prices on the CBT and KCBT were limit up, about an 8 percent move on the former, and a 7 percent move on the latter.  Moreover, the cancellation is undermining Russia’s reputation (yeah, I know) as a reliable trading partner.

Cargill makes the point that Adam Smith made in the Wealth of Nations in the chapter “A Digression on the Corn Trade:”

Cargill, the world’s biggest trader of agricultural commodities, criticised Moscow’s move. “Such trade barriers further distort wheat markets by making it harder for supplies to move from areas of surplus to areas of deficit, and by preventing price signals from reaching wheat farmers,” it said.

Russian exporters argue that the precipitous announcement will make it harder for Russia to export going forward:

Arkady Zlochevsky, president of the Grain Union lobby group, said that the swift imposition of the ban risked undermining Russia’s reputation as a reliable supplier.

.  . . . .

Arkady Zlochevsky, president of the Grain Union lobby group, said the government needed to warn exporters ahead of such a decision and give them time to meet existing contracts, according to Interfax. “What are we to do with the grain that has already reached port?” he asked. “We have no mechanisms for returning it.”

There are understandable domestic reasons for this decision.  It is political, not economic, and reflects the government’s concern about a rekindling (no pun intended, given the current circumstances) of inflation, which has abated in recent months.   The immediate takes precedence over the future, especially in many Russian decisions.

The interesting question is the “coordination” with Kazakhstan and Belarus.  I haven’t been able to find out whether a Union-wide ban would prevent exports from say Kazakhstan to Russia, or just prevent exports from within the Union to without it.  I would imagine the latter.  Since it appears that Russia is hardest hit by the drought, a “coordinated” ban would benefit Russia, at the expense of the other two countries.  Is Russia leaning on the other countries in the Union?  Given recent Belarussian obstreperousness, it will be interesting to see how it reacts.  Will the threats fly?   Reporting I’ve seen doesn’t permit me to answer these questions now, but I will try to keep an eye on how Russia handles this particular issue in the “Near Abroad.”

Update (8/5/10, 2000 CT): Just saw a Stratfor video piece on the grain export ban.  According to Stratfor, (a) Russia is leaning on Kazakhstan and Belarus to export to Russia, rather than elsewhere, and (b) is making it plain that this is a loyalty test.  Loyalty being, like many Russian roads, a one way street.

I finally had a chance to do some preliminary analysis of cocoa data.  My initial findings are that price movements and price-stock relationships during July, 2010 were consistent with manipulation, and unlikely to have resulted from chance in a competitive market.

In brief, I executed the kind of event study described in my 2004 American Law and Economics article on manipulation, which examined the Ferruzzi soybean case.  For a January, 2000-June, 2010 control period, I regressed the change in the log of the July London cocoa price against the change in the logs of (a) the September London cocoa price, (b) the November London cocoa price, and (c) the July ICE New York cocoa price.  (I used the settlement prices for London, and the opening price from New York).  For each year, the data included in the sample runs from 1 March to the last trading day of the July contract.

Given the coefficients from the regression, I then forecast what the log change in the July price would have been for each day in the month of July, and take the difference between the actual log change and that forecast.  I then cumulated these residuals over the month of July, and calculated t-statistics using conventional methods.

The basic result is that the July, 2010 price rose about 6 percent more than one would have predicted, given the movements in the September, November, and July ICE prices.  The t-stat on this cumulative residual is as high as 2.95, which is statistically significant at all conventional levels.  (The p-value is about .1 percent.)  This rise in the relative price of July cocoa is exactly what you would expect to observe during a corner, and given the typical co-movements of all these prices, are highly unlikely to have occurred by chance in a competitive market.

Moreover, the July-September spread was the highest observed–by far–when the contract went off the board, then at any time dating back to 2000.  July was 235 GBP over September when the contract went off the board.  Prior to this year, the biggest back was under 100 GBP/ton.

Stocks rose rapidly in July at the same time that spreads were blowing out.  In a competitive market, you would expect stocks to plummet when spreads moved into a strong backwardation.

The spreads-stocks relation exhibits the typical “supply of storage” (or Working) curve shape, although it is somewhat noisy; backwardation is larger, the smaller are stocks.  By 12 July, 2010,  the stocks were very large for the amount of backwardation in the market.  Or put differently, given the level of stocks, backwardation was unusually large.  This is especially true if one adjusts for the strong downward time trend in stocks observed 2002-mid-2010.  After adjusting for the time trend in stocks, the spread usually associated with the level of stocks observed in mid-July 2010 was a contango of about 20 GBP–nowhere near a backwardation of 250 GBP.

Thus, the market exhibited all the indicia of market power manipulation during July, 2010.  There is no plausible competitive explanation.

The data cast the Sergeant Schultz “I see NUTHINK!” attitude of LIFFE, and the FT’s slobbering coverage of Tony Ward, in a very, very bad light.  The data support a manipulation claim quite strongly; LIFFE’s denials and the FT’s breathless Tiger Beat-esque coverage are very hard to square with this data.   One would have hoped that they would have taken at least a cursory–and skeptical look–at what transpired in the market before declaring that nothing is amiss.  One would have hoped in vain.

Today’s FT runs another cringe-worthy PDA with Anthony Ward of Armajaro.  It is as probing and hard hitting as anything you would expect to read in, say, TigerBeat.  Its tone runs the gamut from credulous to worshipful.

I found the last two paragraphs particularly entertaining:

He is said to argue now as he did in 2002, that all he has done is go to the futures market “to buy cocoa in the most efficient and low-risk way possible”. The trade is likely to bring a stream of profits to Armajaro, particularly if the new Ivorian crop, due in October, disappoints.

Even if prices decline, Mr Ward is unlikely to suffer. A competitor who knows him well has no doubt he will have hedged his position. One admiring executive says: “No one knows the cocoa market better than Anthony.”

Paragraph 1: He’s long cocoa, so if prices rise due to a disappointing crop he reaps a stream of profits.

Paragraph 2: He’s hedged, so if prices fall, he doesn’t lose.  That is, he isn’t long cocoa.

If both of those things are true, he would indeed be a great trader: prices rise he wins, prices fall, he doesn’t lose.  He’s long the upside but not the downside.

How does that work, exactly? I mean, these diametrically opposed statements are in adjacent sentences.  Didn’t an editor think that such a feat was unlikely, or at least sufficiently intriguing to demand further investigation, explanation, and reconciliation?

There is, of course, a way that it could work: Armajaro could be long cocoa puts.  But this seems highly unlikely, as the traded put market is small relative to the deliveries that Ward has taken.  At the very least, though, the tension between the last two paragraphs should have spurred the report to do some actual, you know, investigation and reporting, to see whether the put story has any factual basis, and if so to provide some background on the cost of the puts and its effect on the profitability of the strategy.  And if it doesn’t (as is likely the case), to state forthrightly that Armajaro’s position is a risky one subject to a risk of losses symmetric to the prospect of gains.

But instead the reader gets a breathless fan mag portrayal of the hero who is able to do things that are impossible, or at least so unlikely as to demand further explanation.

This is all bad enough, but nothing compared to the apparent failure to ask any aggressive questions to test the reasonableness of Ward’s denial of squeezing or cornering the market.   If the questions were asked, but not answered, that should have been made plain, or the piece shouldn’t have run at all.  But that would ruin a nice piece of hagiography.

Mr. Ward’s evident hold over the FT is very curious.  An enterprising competitor could do worse than trying to figure out why–after, of course, doing some serious reporting on what has transpired in the cocoa market in recent weeks.

I have a  couple of recent publications that may be of interest to some of you.

A couple of folks have expressed interest in my recent Energy Law Journal paper on manipulation.  Here it is: my policy recommendations are at the end.

Cato just released a Policy Analysis I did on clearing mandates. The link is here: you can download the paper from that page.